We Have Met the Enemy (of our portfolio) and He is Us

When it comes to investing, our worst enemy is ourselves! The theory behind successful investing isn’t rocket science: Buy low, sell high; diversify; invest for the long term, etc. However, practicing successful investing is surprisingly difficult. Certain companies, sectors, and asset classes go from revered to reviled, and vice-versa, practically overnight, and we get so caught up in this short-term “noise” that we lose track of the basic principles of investing. In fact, we don’t just lose track of these principles, our actions tend to be contrary to them. Take a look at the 20-year annualized returns of various asset classes from 1993 to 2013.

As you scale down this mountain of returns, take note of the red bar near the bottom of the pile that reads “Average Investor,” returning about 2.4% annually. Directly to the left of the average investor is the annualized return for 3-month T-Bills (3.0%), or said another way: cash! That’s right, the average investor would have been better off putting their money in a savings account at the bank during this 20-year period.

Our brains simply are not hardwired to make rational investment decisions. We’re over-confident, tend to extrapolate the current environment into perpetuity, become greedy when stocks rise and timid when they fall. For example, during the tech bubble, investors couldn’t resist the siren song of stocks even though prices had become so detached from any reasonable expectation of earnings. On March 9, 2009, the S&P 500 closed at its lowest level in nearly 12 years, however, investors were unwilling to put their money into something where the prospect for short-term losses was relatively high – even though the prospect for such superior long-term returns is only seen once or twice in a lifetime.

How can we gain the self-discipline needed to become a more effective investment manager? Here are a few suggestions:

Know your goals and objectives – Investing is a means to an end, but to what end? Determine how much you need to accumulate in your nest egg. Once you have clearly defined your goals, only then can you begin to invest in an effective manner. Why fixate on keeping pace with the S&P 500 in hopes you will generate returns of 7% – 8% annually if you could achieve your goals with an annual portfolio return of just 3.5%? Furthermore, know your goals early on; this means not waiting. (I could elaborate extensively on the perils of waiting to do financial planning, but that is a discussion for another time…)

Diversify – When it comes to investing, diversification is the proverbial “free-lunch.” This means investing in different types of companies, industries, sectors and asset classes. When one of your investments zigs, you want another to zag, which helps to reduce risk and maximize return over the long term. For younger investors, this may mean allocating a slice of your portfolio to bonds in order to have a place to stash investment gains and replenish depleted stock positions. For older investors, it may mean keeping a chunk of your portfolio in the stock market to ensure your money is not eroded by inflation, against which stocks are a hedge.

Keep fees low – Quite simply, lower costs equate to higher returns. Just as time can compound investment returns in dramatic ways, it also compounds your costs. That means that even the smallest fee can have a huge impact on your money over time. It is imperative that you be conscientious of the fees paid out to your investment manager, the expenses of the investment products and the transaction costs. Review your monthly account statement for any miscellaneous fees and ask your manager to explain their purpose. Ask your advisor how he or she is compensated and by how much. Is it a flat fee, a percentage of AUM, or commission based?

Automate your savings – A dollar in hand is hard to give up. Help offset what psychologists call loss aversion by putting money away before you even take possession of it. Automatically direct money from each paycheck to your 401(k) or emergency fund to avoid having that money parked in a checking account tempting you to spend it. Also, in doing this, you are dollar-cost-averaging into the market, a technique that has you buying more shares when prices are low and less shares when prices are high, which is a highly effective way of dealing with market volatility.

In closing, stop standing between you and superior investment returns. Develop a level of emotional self-control and discipline that will give your portfolio the best shot for success. And get help from an advisor that you can trust, one who will challenge rather than encourage and profit from your emotionally-driven decisions.